Dollarizing Afghanistan

Afghanistan is awash in money. Yet this surfeit of cash fails to provide what any decent monetary system must offer -- a reliable means of payment and a useful store of value. A sound currency is an important component in any plan to restart the Afghan economy and the United States could assist in this process at relatively low cost by dollarizing the Afghan economy.

During their years in the wilderness, the Northern Alliance and the internationally accepted shadow government of Burhanuddin Rabbani did what the Taliban never could. They financed their armed struggle by freely printing Afghan notes that lacked any hard currency backing and watched as it spread disruptive inflation through the rest of the Afghan economy. Major warlords like Rashid Dostum compounded the problem by issuing ample quantities of very similar bills that trade at a discount to the "official" money.

The number of zeros on the Afghani is now so high that it makes transactions awkward, and far too much time and resources are wasted verifying its authenticity and trading the various acceptable types. A new central bank issuing a different currency would only add another spice to the monetary stew. Until the people of Afghanistan view their government institutions as more than a passing phase, no central bank will have the credibility necessary to manage an independent currency.

The average citizen of places like Afghanistan has little access to anything recognizable as a banking system or financial markets. Instead, money -- most of which is held as cash -- is perhaps the most important financial asset.

Also almost nonexistent in Afghanistan is bank lending for productive investment. Instead a farming family that wished to buy tools, or a melon wholesaler who needed a new cart would self-finance these purchases by accumulating the needed cash. Simple investments like these are often the easiest ticket out of poverty for millions. Yet rapid inflation has made even cash a poor vehicle for financing small farm improvements or minor capital purchases. Instead, people hoard things that depreciate in value less readily, like gold or consumer goods. Barter replaces a monetized economy and the capital stock slowly falls into disrepair.

The best way to solve such problems and restore a stable monetary system would be to dollarize the Afghan economy. The cost of doing so should not be prohibitive, particularly in comparison with the price tag of many aid projects. Fully dollarizing Afghanistan so that each citizen holds roughly $100 (the same amount as in neighboring Pakistan) would require a cash infusion of perhaps $2 billion.

The real cost to the U.S. of issuing this new currency would be negligible, as the money would not be shipped back in exchange for goods that Americans would otherwise consume. Instead it would remain in Afghanistan to facilitate transactions and private saving decisions among Afghans. Dollarization would actually benefit the U.S. since, if the Afghan economy begins to grow, rising incomes would fuel an increased demand for dollars. The U.S. could then consume imports without having to export anything but paper money in return. This seignorage is like a small rental fee paid by Afghanistan for using the dollar as its national currency.

Successful dollarization would get cash into the hands of the average Afghan without rewarding the warlords who sit atop the printing presses. A portion of the funds could be allocated per capita with the remaining dollars exchanged for local currency at realistic exchange rates, perhaps subject to a maximum allocation per person.

With a sound currency in place, the government of Afghanistan could use its limited technical expertise to establish a transparent regulatory apparatus to monitor a regenerated private banking system, and to develop a government credit agency with sufficient international reserves to act as a lender of last resort. If Afghanistan wanted to regain control of its monetary policy at some point in the future, this agency could evolve into a central bank with the power to issue a national currency. Once national institutions recover sufficient credibility, they could use that currency to buy back dollars to return the initial stake to the U.S.

Despite these virtues, arguments against dollarization aren't hard to find. Moderate inflation is a good source of government revenue in nations where tax systems are rudimentary. To inflate, you have to have a central bank that controls the amount of domestic currency in circulation and a dollarized economy has no such agency.

But inflation often becomes a crutch and the advantage of dollarization is that it encourages a government not only to live within its means but also to develop a simple, broad-based tax system. In a dollarized regime there can be no cycles of runaway inflation so destabilizing to a poor economy.

Perhaps the most common anti-dollarization argument today is summarized in a single word -- Argentina. That sad nation's descent into economic chaos is attributed by many to its rigid use of a currency board whose statutory responsibility was to maintain a dollar in reserves for each peso it issued -- dollarization de facto.

As the dollar rose in value against the yen and euro in the late 1990s, demand for Argentina's increasingly overpriced goods fell. Neighbor Brazil's currency collapse in 1999 exacerbated Argentina's recession and stimulated fears the government would break the dollar-peso link and devalue. Last spring, hints the government might default on its debt triggered the final crisis and the currency collapse was on. Why would anyone want to replicate this mess in Afghanistan?

The overvalued peso indeed contributed to Argentina's woes, but the core problem was the Argentine political leadership's failure over many years to build a sound fiscal structure. Argentina's provinces faced little pressure to restrain spending, and the tax collection system in Argentina remains one of the least efficient in all of Latin America. Widespread tax evasion squanders up to half of Argentina's potential fiscal revenue in ways that have bred corruption and public disrespect for social institutions.

The Argentine experience shows that a first world appetite for public spending cannot coexist for long with a third world tax system. Afghanistan's government has no such appetite, and dollarization will help ensure it doesn't develop.

Of equal importance, Afghanistan differs from Argentina in ways that make dollarization more sustainable. Argentina's highly political unions don't make for a very flexible labor market. Wage rigidity is why a currency overvaluation causes increasingly uncompetitive tradable goods industries to collapse, sending recessionary ripples through the economy. A rise in the value of the dollar need not affect the competitiveness of a dollarized economy's goods if offsetting changes in local wages and prices are possible, and Afghanistan begins with much greater wage-price flexibility.

Dollarization is not a cure-all for Afghanistan's fractured economy. The primary tasks are consolidating the power of a legitimate central government and expanding the reach of an impartial judicial structure. Progress on these will assist the more mundane tasks of building a banking system and developing sound public finances. A stable monetary system based on the dollar would assist the Afghan government in achieving these goals, and there is no reason to wait.

Updated May 20, 2002

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